Dr. M.D.

Chase
Advanced Accounting 510-42B

Long Beach State University

Review Problem with Intercompany Bonds
Page 1

I. INTERCOMPANY BONDS: Comprehensive (old CPA Examination) Review Problem

On June 30, 19x7 "P" Inc. purchased 90% of the outstanding common stock of "S" Inc. for "P" C/S valued at $4,100,000 and
cash. at the date of purchase, the BV and FMV of "S" assets and liabilities were as follows:
Balances as of 6/30/x7:
Cash.........................................
Accounts receivable (net).....................
Inventory.....................................
Building......................................
Furniture, fixtures and machinery.......
Accumulated depreciation......................
Intangible assets (net).......................

Accounts payable.............................
Notes payable................................
5% mortgage note payable.....................
common stock.................................
Retained earnings (6/30/x7)..................

**

BV
160,000
910,000
860,000
9,000,000
3,000,000
[5,450,000]
150,000
8,630,000
$[ 580,000]
[ 500,000]
[4,000,000]
[2,900,000]
[ 650,000]**
[8,630,000]

$2,605,000

FMV
Difference
160,000
-0910,000
-01,025,186 $
165,186
7,250,000
[1,750,000]
2,550,000
[ 450,000]
-05,450,000
220,000
70,000

[ 580,000]
[ 500,000]
[3,710,186]

-0-0289,814

3,775,000

This represents RE balance if books were closed at 6/30/x7

--On 12/31/x7 the net balance of "S"'s accounts receivable at 6/30/x7 had been collected; inventory on hand at 6/30/x7 had been charged to
Cost of goods sold; accounts payable at 6/30/x7 had been paid; the $500,000 note had been paid.
--On 6/30/x7, "S" building and furniture, fixtures and machinery had an estimated remaining life of ten and eight years, respectively.
--All intangible assets had an estimated remaining life of 20 years.
--All depreciation and amortization is to be computed using the straight-line method.
--On 6/30/x7, the 5% mortgage note payable had eight annual payments remaining, with the next payment due 6/30/x8. The fair value of the
note was based on a 7% rate.
--Prior to 6/30/x7 there were no intercompany transactions between "P" and "S"; however, during the last six months of 19x7, the following
intercompany transactions occurred:
a. "P" sold "S" $400,000 of merchandise. The cost of the merchandise to "P" was $360,000. $75,000 (based on sales price) of this
merchandise remains in 12/31/x7 inventory.
b.

On 12/29/x7, "S" purchased in the open market $300,000 of "P" Inc. 7-1/2% bonds payable for $312,500, including $22,500 interest
receivable. "P" had issued $1,000,000 of these 20-year bonds on 1/1/x0 for $960,000. This price reflected a market rate of 7.90452%.

c.

Many of the management functions of the two companies have been consolidated since the merger. "P" charges "S" a $30,000 per month
management fee.

d.

On 12/31/x7 "S" owes "P" two months' management fees and $18,000 for merchandise purchased.

--Assume that both companies have made all adjusting entries required for separate financial statements unless an obvious discrepancy exists.
--Trial balances for "P" and "S" are presented on the following page:

Dr. M.D. Chase

Advanced Accounting 510-42B

Long Beach State University

Review Problem with Intercompany Bonds
Page 2

--Trial balances of "P" and "S" on 12/31/x7 are presented below:

Balances as of 12/31/x7:
"P" Inc.
Cash........................................
$
507,000
Accounts receivable (net)....................
1,883,364
Interest receivable..........................
Inventory....................................
2,031,000
Building.....................................
17,000,000
Furniture, fixtures and machinery............
4,200,000
Accumulated depreciation.....................
[8,000,000]
Intangible assets (net)......................
Investment in "S"............................
6,705,000
Investment in "P" 7-1/2% bonds (net).........
Accounts payable.............................
[1,843,000]
Interest payable.............................
[ 200,500]
5% mortgage note payable.....................
[6,786,500]
7-1/2% bonds payable.........................
[1,000,000]
Discount on 7-1/2% bonds.....................
30,636
8-1/4% bonds payable.........................
[3,900,000]
common stock.................................
[8,772,500]
Retained earnings (12/31/x6).................
[2,167,500]
Sales........................................
[25,000,000]
Cost of goods sold...........................
18,000,000
Selling, general and administrative expenses.
3,130,000
Management service income....................
[ 180,000]
Management service expense...................
Interest expense.............................
662,000
Depreciation expense.........................
3,701,000
Amortization expense.........................

"S" Inc.
200,750
817,125
22,500
1,009,500
9,000,000
3,000,000
[6,050,000]
146,250
290,000
[ 575,875]
[ 100,000]
[4,000,000]

[2,900,000]
[ 450,000]
[ 6,200,000]
3,950,000
956,000
180,000
100,000
600,000
3,750

REQUIRED:
a. What method of accounting is the parent using? How do you know?
b. Analyze the investment
c. present the amortization table for the 7-1/2% bonds
d. present the consolidated elimination entries
e. compute total net income, MI net income and controlling interest net income
f. present the consolidated working papers for 12/31/x3 in good form

Dr. M.D. Chase

Advanced Accounting 510-42B

a.

b.

Long Beach State University

Review Problem with Intercompany Bonds
Page 3

SOLUTION:
What method of accounting is the parent using? How do you know?
This is a purchase and it appears that the parent is using the cost method because no adjustments have been made to accrue subsidiary
net income or adjust the investment account for the parents share of net income and we have been told to assume all required
adjustments have been made on the books of the separate companies. Since this is the first year of the purchase, no conversion entry to
equity method is necessary because the investment account is still carried at is beginning of year balance and no dividend income has been
received.
Analyze the investment
Cost (FMV of stock + cash = $4,100,000+$2,605,000)...........
Purchased BV: C/S:
$
2,900,000
PIC:
-0RE:(BOY)
450,000
$
3,350,000 (.9).......................
Purchased net income: (650,000-450,000)(.9)...
Interest Acquired........................................
Excess of Cost over book value...............................
Add: Preexisting GW....................................
Adjusted excess:........................................
Attributable to:
FMV accounts (CA;Liabilities;MES):
Inventory (1,025,186-860,000)(.9)..........
Mortgage payable (4,000,000-3,710,186)(.9).
Total to FMV accounts..................
Available to NCA:
(10yr) Building (7,250,000-9,000,000)(.9)........
( 8yr) FF&M (2,550,000-3,000,000)(.9)............
( S/L) Accumulated depreciation (0-5,450,000)(.9)
(20yr) Intangibles (net) (220,000-150,000)(.9)...
Total to NCA...........................
(20yr) Balance to Goodwill......................
Total accounted for..............................

6,705,000

3,015,000
180,000
3,195,000
3,510,000
-03,510,000

148,667
260,833
409,500
3,100,500
[1,575,000]
[ 405,000]
4,905,000
63,000
2,988,000
112,500
3,510,000

c. present the amortization table for the 7-1/2% bonds

7.5%
7.90452
Date
Payment Interest
Amort.
1/1/x0
12/31/x0 $ 75,000 $ 75,883 $883
12/31/x1 75,000
75,953
953
12/31/x2 75,000
76,029
1,029
12/31/x3 75,000
76,110
1,110
12/31/x4 75,000
76,198
1,198
12/31/x5 75,000
76,292
1,292
12/31/x6 75,000
76,394
1,394

Discount
$ 40,000
39,117
38,164
37,125
36,025
34,827
33,535
32,141

CV
$960,000
960,883
961,836
962,865
963,975
965,173
966,465
967,859

12/31/x7

75,000

76,505

1,505

30,636

969,364

12/31/x8

75,000

76,624

1,624

29,013

970,987

Dr. M.D. Chase

Advanced Accounting 510-42B

a.

b.

c.

Long Beach State University

Review Problem with Intercompany Bonds
Page 4

d. present the consolidated elimination entries

* Convert to equity method: Not necessary in first year because no changes are booked in Investment account BOY under either method;
eliminate the current year investment account entries (those entries that the parent "booked" IAW APB-18 (equity method) of
SFAS-12/115 (cost/FMV method) accounting;
Dividend income ............................ -0Dividends..............................
-0eliminate the parents pro rata share of the subsidiary SHE accounts (RE; C/S; PIC in excess of par)
(P%)"S" C/S (.9)(2,900,000)................
2,610,000
Purchased net income.......................
180,000
(P%)"S" RE...(.9)(450,000).................
405,000
(P%)"S" PIC in excess of par..........
-0Investment in "S".....................
3,195,000
allocate the purchase differential (difference between cost and purchased book value) per analysis of the investment
(NOTE: Recall that the investment in "S" account should be eliminated at this point)

Cost of goods sold (inventory).............

Mortgage note payable (per analysis)...
Intangibles.................................
Goodwill....................................
Accumulated depreciation....................
Building...............................
FF&M...................................
Investment in "S"......................

148,667
260,833
63,000
112,500
4,905,000
1,575,000
405,000
3,510,000

NOTE: In the CPA examination or (problems using incomplete data)

any remaining amount necessary to balance (after the C entry should
be assigned to consolidated retained earnings; this will never happen
in practice because you will have access to complete data.

d. amortize the amounts allocated STEP C. above that will effect net income of parent as it picks up its pro rata share of equity in "S"
earnings;
*

Amort. Exp-intangibles (.9)(70,000/20)(.5)..

Interest expense-mortgage N/P...............
Depreciation expense........................
Discount on Mortgage N/P (.9)(29,857)..
A/D (diff. between "P" and "S" books)..
Intangibles............................

**

7% effective interest on mortgage

5%
Date
Interest
12/31/x7
$200,000

Depreciation per "P" books:

Building (.9)(7,250,000)(1/2 year)/10....
FF&M (.9)(2,550,000)(1/2 year)/8.........

1,575
26,871**
169,688*
26,871
169,688*
1,575

326,250
143,438
469,688
Depr on "S" books (600,000)(1/2 year).
300,000
Adjustment required..................................... 169,688

note payable, therefore the discount is amortized at 7%:

7%
Interest
Amort. Discount CV
$259,713 $59,713 $289,814 $3,710,186

1/2 year of annual amortization = $ 59,713/2 = 29,857 x [% ownership (.9)] = $26,871

e. Eliminate intercompany sale of merchandise: (Downstream sale)

Sales.......................................
400,000
Cost of goods sold.....................
400,000

You must compute (estimate) the amount of profit in ending

inventory. You can do this based upon the numbers provided
*

f. Eliminate profit in Ending inventory:

Cost of goods sold (75,000)(.1)*..
Inventory..............................

7,500
7,500

original cost: $ 360,000

sales price:
400,000
profit:
$
40,000 or 10% of sales price; therefore 10%
of the value of ending inventory represents profit.

Dr. M.D. Chase

Advanced Accounting 510-42B

Long Beach State University

Review Problem with Intercompany Bonds
Page 5

g. Eliminate intercompany bonds:

Bonds payable (face value BOY)..............
Investment in bonds (CV BOY)...........
Gain on bond retirement (per analysis).
Discount on bond inv. (30,636)(.3).....

300,000
290,000
809
9,191

Short-cut Analysis to Computation of

(Gain)/Loss on Intercompany Bonds
Traditional Analysis to Computation of
(Gain)/Loss on Intercompany Bonds

CV of bonds on 12/29/x7: $
Percent intercompany:
CV of intercompany bonds: $
Cost of intercompany bonds:
(312,500-22,500)..........
Gain on retirement.........

Issue
Discount

Purchase
Discount

969,364
.3
290,809
290,000
809

Face Value

(Refer to amortization table )

h.

$ 9,191
($30,636 x 3)
$10,000

Eliminate interest on intercompany bonds payable:

Interest payable (300,000)(.075)............ 22,500
Interest receivable.....................
22,500

$809 Difference

i. Eliminate other intercompany expenses:

Management service income................... 180,000
Management service expense.............
180,000
j. Eliminate other intercompany payables:
Accounts payable (30,000)(2)+18,000. 78,000
Accounts receivable....................

78,000

e. compute total net income, MI net income and controlling interest net income

_
Sales........................................
Cost of goods sold...........................

"P" Inc.
[25,000,000]
18,000,000

Selling, gen and admin exp.

Management service income....................
Management service expense...................
Interest expense.............................
Depreciation expense.........................
Gain on bond retirement......................
Purchased net income.........................
Amortization expense.........................

3,130,000
[ 180,000]
662,000
3,701,000

"S" Inc.
[ 6,200,000]
3,950,000

Adjustments/Eliminations
Dr
CR
400,000
7,500
{ 400,000]
148,667

956,000

4,086,000
180,000

180,000
100,000
600,000

[ 180,000]
26,871
169,688
[

313,000*

3,750
[410,250]

3,569]

180,000
1,575

1,114,301
[583,569]
*Note: this amount is a loss!
Total net [income] loss.............................................................................
to Minority interest (MI%)(SIGNI+UPCR-UPDR)=(.1)(410,250)...........................................
to Controlling interest PIGNI+P%(SADJNI)+DNCR-DNDR)= -313,000+(.9)(410,250)+583,569-1,114,301.......
Note:

Consolidated
Net Income
[30,800,000]
21,706,167

788,871
4,470,688
[ 3,569]
180,000
5,325

433,482 loss
[ 41,025] income
474,507 loss

Pay particular attention to the relationship of the Investment Analysis and the distribution of net income. If necessary refer
back to handout 305-25B